6 June 2000
Michael Folger
Director, Investment Business, FSA

[TITLE SLIDE]

I have been asked to speak this afternoon on regulatory requirements for on-line trading.

This - the first session after lunch – is traditionally the graveyard shift for any conference speaker. So it is important that I don’t drift off into long philosophical conjectures. I mean to stay in the here and now, speak for 30 minutes and then take questions for 5 or 10. In questions I would be pleased to cover wider aspects of the FSA’s metamorphosis into a seamless regulator, and the state of play on the Financial Services and Markets Bill.

But I focus my prepared remarks so that they dovetail with the rest of the programme.

You have heard this morning from Stephen Wilson of Tradepoint – a recognised investment exchange offering electronic trading.

ATSs, RIEs, order execution

He will have taken you through the emerging role of ATSs – electronic networks operated by firms – which are not constituted as exchanges. In the U.S. the role of such networks has grown rapidly. And they have the potential to do the same in Europe. That is one driver for the alliances between various of the European exchanges.

The scene is certainly an active one, with Tradepoint itself looking to start trading European equities from next month, adding to the UK equity business it already does. Jiway, the new electronic exchange for European equities, is coming down the slipway. Aiming to service retail brokerages in particular, its application for UK recognition is now under consideration. Just yesterday trading started on Coredeal, a newly-recognised UK exchange, owned by ISMA and 13 leading Eurobond houses, which trades Eurobonds electronically. I should mention, too, derivatives and commodities markets, where on-line trading is also now well-established. The bottom line is that across a wide range of products, through RIEs or ATSs, on-line order execution is well established.

We could hold a whole conference on ATSs, RIEs and the fading differentiation between electronic order-matching done through exchanges or by firms as principals. At the European level, in particular, a separate issue to be cracked is provision of efficient cheap settlement. I am pleased to see that you have two sessions on that, from Philip Reichardt and Clive Triance, later this afternoon. Here in London, recent problems with the residual stocks not eligible for CREST are an example of how the "tail" of settlement can still wag the "dog" of securities trading, whether that trading is done by electronic or other means.

Market Fragmentation

In terms of order execution in the on-line world, there is just one issue I would like to hold up to the light. This is a tendency to market fragmentation as business splits across competing RIEs and ATSs. The new platforms are enabled by technology radically cheaper to run than the dealing floor of a traditional exchange. But, with that single dealing floor no longer the only place where demand and supply meet, then price formation and market efficiency could be damaged. Though arbitrage should limit the scale of price differences, transparency suffers if the prices obtainable vary between one trading platform and another.

In practical terms, the implications really split into two.

Where a particular trading platform comes to account for a significant part of price information, then it is clearly down to the regulator to consider whether some broader transparency is required.

Where on the other hand there is a possible need to link up information already available from various trading platforms, the market should in principle be able to generate a commercial solution. I could foresee circumstances in which we might consider it desirable to promote a consolidated quote or trade publication system –probably for Europe rather than just the UK. But we would have to ask very careful questions as to why there was no market solution before we involved ourselves further.

Some institutional players already subscribe to Plexus, a co-operative sharing of information on the prices at which trades are done on a variety of platforms. This is one way they can check how well their dealers are doing.

Best Execution

Clearly, however far the ATSs develop this side of the Atlantic, the availability of different price feeds does pose some issues for firms’ duty to secure "best execution" for private investors. How do we interpret that regulatory requirement in a world where the Retail Service Providers can issue a standing guarantee, to brokers using them, that they will match or beat the SETS price?

[SLIDE A]

In April, SFA Board Notice 542 gave updated guidance. It reaffirmed, for equities, on a pragmatic basis, the link to the SETS price. It said the firm should get its customer the best price available from the price feeds to which it subscribes, though it is not obliged to have access to all possible price feeds.

The approach FSA proposes to apply on best execution from N2 – the date in the first half of next year when we take over regulation of securities firms under the new legislation – will be set out for consultation by the end of this month. For the longer term policy on best execution, the market developments which we all recognise necessitate a more wide-ranging review. This will need to cover derivative and other products, as well as equities, where best execution is required. We plan to issue a Consultation Paper on the subject by the end of this year. Broadly speaking, the issue is probably whether one becomes more prescriptive in requiring firms to search out competing prices. Or should we continue to rely on the more general duty of best execution, coupled with a more rigorous requirement on firms to be able to demonstrate how they achieve it in practice?

"On-line trading" for the consumer

On-line order execution has been the key to making on-line access for the individual investor more than a fancy form of fax machine. It enables straight-through processing of customer orders. But in many respects it lies "behind the green baize door" for the retail investor. So let me turn to "on-line trading" as the retail investor experiences it. I take that perspective not least because the way business is conducted with those consumers is a key driver for the work of my division at FSA.

Almost as an aside, I point-up one very specific reason why I take a close personal interest in all this: so often it seems to be me taking the media flak when execution-only firms have not sustained service levels for retail business on the telephone! I hope and believe that, for the long run, internet-based means of accepting customer orders, which are then executed electronically too, is likely to be the more robust model. Going on-line with the whole value chain must be the way to avoid bottlenecks, once the systems are demonstrably robust.

So, I have declared my hand. From FSA we see on-line trading as offering new value for the consumer wanting to deal execution-only. It enables him or her to do bargains at radically lower cost than through traditional means of doing business. And progressively it is bringing price and company information, plus research, direct to the investor’s PC screen at low or no cost. The internet seems to have opened up a whole new market.

[SLIDE B]

The APCIMS/ComPeer share trading survey estimates on-line private client bargains in London more than doubled in the March quarter – to 930,000, done through 155,000 on-line accounts. A year earlier, on-line bargains numbered at just 31,000. UK-authorised on-line brokers number 30 odd today, compared with just a handful 12 months ago.

That is remarkable growth, taking internet trades to about a quarter of total execution-only bargains. Interestingly, by value of consideration that proportion was only about 12%. The on-line investor seems to have been dealing in relatively small lots – around £3,000 a time. The low costs make that economic for the consumer. And, despite the hype about day-trading, according to the APCIMS/ComPeer survey, the average on-line account trades just 24 times a year.

For completeness in this sketch of retail on-line broking, I note that, since the correction in new economy stocks in March, the total volume of execution-only business does seem to have come off the boil. Compared with daily volumes peaking in excess of 100,000 bargains in February and March, signs are that through May volumes were more like 70,000 a day. It will be interesting to see how that adjustment has been borne between on-line and other forms of business.

Regulatory Issues

Against that background, what are the key on-line trading issues for the regulator? FSA’s statutory duties, as proposed in the Financial Services and Markets Bill, will be

[SLIDE C]

Market confidence

Public awareness

benefits and risks of different kinds of dealing

provision of information and advice

The protection of consumers

appropriate degree of protection

having regard to varying consumer experience/ expertise

The reduction of financial crime

The market fragmentation issue, on which I commented earlier, has to be addressed under the market confidence objective. In looking to achievement of our other objectives, we need to look at the threats, as well as the opportunities, which on-line trading is bringing.

The Bill obliges the FSA, in discharging its general functions, to have regard to some key principles of good regulation. I highlight in the present context:

[SLIDE D]

regulatory burdens/ restrictions are to be proportionate to the benefits

the desirability of facilitating innovation

minimising adverse effects on competition

the desirability of facilitating competition between regulated firms

Note in particular that, unlike any other financial regulator in the world of which we are aware, FSA will be required to take account of the desirability of innovation. So, even if we wanted to be Luddites, Parliament says we should not be.

We have to find a way of adapting our regulatory approach to new technology, not adapting the new technology to the old regulatory rules.

But that does not mean abandoning the principles on which financial services regulation has, for good reason, been built. Indeed, I would argue that it would be positively mistaken to abandon those principles in the belief that it is somehow necessary to encourage the spread of e-commerce generally or on-line trading specifically. Indeed some consumers’ reluctance to embrace the new technology comes from their anxiety about the risks they run in doing so. Who does ensure that the attractive offers they read about are soundly based? How safe is it to pass a credit card number down the line? Is there a cooling off period for Internet investments, as there is through other investment methods? Do the compensation and complaints arrangements still apply?

Unless we can give people some reassurance that the normal backstop protections still exist, we will restrain the growth of new technology, rather than encourage it. So the fundamental principles of consumer protection, transparency and disclosure should apply.

The key risks

So much then for the scene-setting. I would like to take you through our current approach under three basic headings. It seems to me that on-line trading means

[SLIDE E]

some old risks, applying to the new set of less experienced consumers who have been drawn in to share investments; and

some new risks, applying to all on-line investors;

Finally, it also brings

some specific risks firms must control through their management of the new technology.

Old risks faced by new consumers

A big part of FSA’s concern has to be for the many less experienced consumers, who seem to have been drawn to the buying and selling of shares for the first time. Like any novice investor, whatever technology they are using, they need to learn the ropes. From any bulletin board you can see some astonishingly basic questions that investors ask only after they have bought shares. We have to remember that they are dealing on an execution-only basis, without the benefit of advice. So there are some elementary traps waiting for them:

not understanding that prices can, and do, rise and fall very quickly;

not knowing about limit orders, to make their transactions conditional on what they see as an acceptable price;

not understanding the benefits of a diversified portfolio;

taking speculative "punts" with money they cannot afford to lose;

being too credulous about comment and speculation on share values.

To reduce these risks to consumer protection, and to promote public understanding, we have given clear warnings and made information available, focussing particularly on the dangers of day-trading through a Consumer Alert released to the press and posted on our own web-site. We have also issued a specific Alert about the need to use bulletin boards intelligently, as just one source of information which may not always be reliable.

[SLIDE F]

Direct communication with consumers is a relatively novel tool for regulators in the UK. But we see it as an appropriate and cost-effective way of reaching the unwary who are dealing on their own initiative.

New risks for all consumers

The internet does not respect jurisdictional boundaries and it makes it possible for UK investors to transact on-line with firms in overseas jurisdictions. If someone does that with a US firm, for example, that’s their decision, and the US is a well-regulated jurisdiction. But there are others, also accessible at the click of a mouse, where regulation is less well-developed. In my view this step change in the accessibility of overseas firms amounts to a new risk as well as a new opportunity for all consumers. At the most basic level, they need to know the jurisdiction from which the firm they are dealing with is operating. That, and the need to be clear what protections do and don’t apply, is again something made clear on the FSA consumer website.

It is quite clear that the old concept of purely national regulation is not going to be adequate in the future. In a sense, in Europe we are already ahead of the game, with a network of home state/host state responsibilities already in place – at least in theory. So FSA is responsible for ensuring that any UK firm deals with its customers fairly and properly wherever they are in the EU. And the same is true of European firms from other member states, using their EU "passport" to do business here.

But the mechanisms of co-operation need to be strengthened, and are being strengthened.

An IOSCO Task Force has identified five principles for regulation of securities business done on the internet, with which the FSA approach is fully consistent More tangibly, though still via the ether if you see what I mean, IOSCO co-ordinated a co-operative day of Internet surfing on 28 March. This involved regulators from 18 countries. I will not comment in too much detail on what we found, beyond saying that the FSA’s team spotted 53 UK sites which merited further investigation.

The bottom line in our release on this, given by my colleague Dan Waters, was:

[SLIDE G a,b,c]

Again the emphasis on disclosure and transparency.

The actual and perceived security of transactions is a crucial issue for novice or experienced investors dealing on-line. Firms have important responsibilities for proper control of their affairs, including adequate risk management [FSA Principle 3] and for paying due regard to customers’ interests [FSA Principle 6]. So firms need to be confident that their on-line systems are secure and not prone to malfunction or malfeasance which will harm consumers’ interests. Taking that into account and against the background of the Electronic Communications Bill, the FSA has explained its intention that verifiable electronic signatures will generally be taken as equivalent to a traditional "wet" signature. This was made clear on the release in February, for consultation, of the draft Conduct of Business Sourcebook to apply from N2.

[SLIDE H]

This will mark a change from the approach SFA has maintained historically, under which an electronic signature is not acceptable for executing a customer agreement. So a would-be customer can print-off an application form on-line. But he or she must then physically return it to the firm, completed with a "wet" signature, before trading can begin.

This requirement reflects in part a concern about the possibility of an inexperienced consumer, in his or her surfing of the net, entering a firm’s website out of curiosity then proceeding headlong to start dealing securities. Clearly that is a danger. And some consumers may think the better of an initial enthusiasm if they have to break off and, with a built-in delay, execute and return a wet signature.

However given the warnings we are now getting direct to consumers, we shall be reviewing next steps with SFA. Ahead of N2, there may be scope for amending the SRO’s rulebook to allow verifiable electronic signatures to be recognised for customer agreement purposes.

Risks for new firms to manage

Let me move to a close now with the third of my categories of risk: things the firm needs to manage. And, as is traditional, it may just mean some homework for some of you to take away. But I leave you to judge that.

The regulator’s broad approach, as I have described it, is to work towards a risk-based model of regulation which is technology neutral. Our conduct of business rules, for example, are not specific to particular technologies which may be used for doing business. And the Principles for Business, and senior management responsibilities for seeing them through, are certainly not.

But, equally, whether it is ensuring you don’t run out of postage stamps or that your on-line software is robust, the obligation for responsible organisation and control does not depend on the technology you have chosen to use. Whether it’s Edwardian or new millennium technology, FSA’s planned Principle 3 for businesses explicitly requires an adequate risk management system.

[SLIDE J]

Of course the FSA, as a regulator recognising the desirability of innovation recognises that sometimes, despite best practice trialing and testing, new software and systems will fall over. I need not name names, but we have seen some pretty arresting failures of on-line systems over the past 12 months. Mercifully, these have generally been short-lived. We are in dialogue with the firms over the reasons, and ways of minimising the risk of recurrence. There are some common-sense steps. For example, weekend software modifications are convenient for the IS Department but may not be smart if the first live run is on a Monday morning when all your investors, fuelled by the weekend press, are itching to deal.

We understand, too, that it is healthy for firms to compete in the services their websites and software can offer customers. But, in all this, we need to see a balance: not bringing new products on stream until there is confidence in their robustness. And risk management demands that fall-back systems – yes, even the telephone – are available to ensure that customers’ interests can be protected where on-line systems fail.

A reminder too, that firms’ and senior management’s, responsibilities to organise and control their business responsibly and effectively cannot be contracted out. By all means outsource systems, but a firm must still take reasonable care to supervise the discharge of outsourced functions by its contractor. It is a real challenge for a firm’s management to ensure they have available the technical ability to do that properly. And it’s a challenge too for the regulator to build and sustain the expertise required to probe in that area. With the robustness and security of the new technology so crucial to consumers’ interests, both the industry – especially senior management – and the regulators have big and complementary responsibilities.

That is my spin for you this afternoon on a "balanced approach", not hampering innovation in on-line trading.

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